Investing, Philadelphia StyleLand ownership once was the only practical form of savings, until banking matured in the mid-19th century. Philadelphia took an early lead in what is now called investment and still defines a certain style of it.

Personal FinanceThe rules of financial health are simple, but remarkably hard to follow. Be frugal in order to save, use your savings to buy the whole market not parts of it, if this system ain't broke, don't fix it. And don't underestimate your longevity.

Reflections on Swensen

A. Techniques of rebalancing. Three directions to take this, occur to me.

1. Purchase 60/40 mutual funds and let them do the rebalancing. This would offhand seem the easiest way to do it, but what are the results? Do you think it would be practical to construct a 60/40 mutual fund by combining and rebalancing a world-wide index fund with a bond fund? Since bond funds are dubious, how about a mutual fund that contained the equity index fund and did its own bond juggling? How about a family of funds, mixing 50/50, 55/45, 60/40, 65/35, 70/30, 75/25. 80/20, as the investor chooses? Since this would probably amount to a pool that sold virtual shares, almost any combination seems feasible. But is it legal? At one time the fund of funds was illegal for whatever reason; possibly Vanguard has a right to object to such a secondary use of its funds. By getting a fund together, there should be enough volume to consider real-time rebalancing. When you consider doing it for yourself, the fund approach seems increasingly attractive.

2. Establish two brokerage accounts at Vanguard, one for equities and one for bonds, each of which is linked to its own separate money market sweep fund. Monthly rebalancing should be possible from the monthly statement, with the money market of one account purchasing shares of the other asset class as needed for rebalancing. A refinement of this might be to purchase shares of the "wrong" account and hold them until the capital-gains period has expired, then transfer to the "correct" account. I presume that transfers between two money-market accounts would be fairly simple, avoiding the perplexities of buying shares with one account but depositing them in another. Adjusting the order to reinvest dividends or not reinvest seems like a nice refinement, lessening the need to sell things.

3. Doing the whole business in Quicken. If you are thinking of doing this for clients, you might want to avoid the hazards of actually doing the transactions, simply sending the client a set of suggested monthly instructions to give to his broker or transact electronically. This might seem attractive to people running trust funds, who already carry the fiduciary hazard.

B. Selecting or deselecting, those companies who regularly rebalance their own debt/equity ratios. One of the important insights I get from Swensen is that company treasurers are often rebalancing in the opposite direction from the investors. That is, issuing more stock as their price/earning ratio gets ridiculously high, buying back their stock when the price gets cheap. Not all companies do this, and those who do probably reduce their volatility considerably. If this is a really major reason for investors to rebalance in the other direction, then there may be a considerably reduced value in rebalancing companies that are doing it for you, and an enhanced value in rebalancing the rest.

1. Since you don't know the intentions of a company, and anyway they may change treasurers without your knowledge, there is a need to find some surrogate for this activity. That's particularly true of companies that may only do it in one direction, and thereby alter the balance between raising equity capital and borrowing. Does the p/e ratio seem adequate to you as a surrogate? If not, is there a practical alternative?

2. I've been told that small companies borrow from banks, large companies issue bonds. Is this of any practical value to an investor? Are they a distinct asset class? After all, you can change your debt/equity ratio by adjusting either component, or you can reduce your total external capital requirement by using internally generated funds. Does this issue get you anywhere in selecting asset classes?

3. Companies or asset classes with a lot of volatility apparently give Swensen an opportunity to rebalance profitably. Aside from that, it is better for a company to have low volatility or high? If all companies got religion and did their own rebalancing, would there be any value in investors continuing to do it? To put it another way, just where is the value added by rebalancing? What signs would you look for, to decide that rebalancing is no longer cost effective?

C. Life insurance to reduce taxation. The October 18, 2006 Wall Street Journal observes that the IRS has issued clarifying instructions about using life insurance to reduce taxation; it also goes on to say that lawyers will charge you $10-20,000 to read them to you. But, apparently it's ok to do this if you follow the rules. Essentially, life insurance investments compound internally without taxation, and also escape estate taxes if you donate ownership of the policy to your heirs.

1. In the case of a spousal trust, the estate taxes are already waived, so one complexity is reduced or eliminated. There is no need to transfer ownership of the policy.

2. So the issue reduces itself to avoiding dividend and capital gains taxation, short and long. I gather they have not thought of the requirement to distribute all income from a spousal trust, so there is a chance some agent would balk at the technicality.

3. So, except for this risk, it's a simple trade-off between the fees for insurance versus the taxes saved, and I strongly suspect the fees are worse, so the issue isn't worth considering at all. But of course I don't know what the fees are, so I don't know the threshold level where tax avoidance becomes an important asset. Even the health issue is semi-answered, since you could escape a physical exam by selecting an annuity life insurance; more fees to overcome, of course.

D The same Wall Street Journal includes a quotation from unknown research that calculating the dollar value weighting of mutual funds versus fund results demonstrates that all reasons for not buying-and-holding combined show a 1.5% penalty for all strategies other than buy/hold.

1. Therefore, the 0.5% advantage of rebalancing over buy/hold is actually a 2.0% advantage over the penalty for deviating. That's a more substantial argument than has so far been made for rebalancing, but needs to be re-examined to be sure the penalty is not actually hidden in the 0.5% claim, since if so that would convert it into a 1% loser strategy.

2. For no visible reason, broker-handled funds average 0.5% lower return than direct-buy funds. May I suggest some hidden kick-back has surfaced?

3. Low-volatility stocks seem to produce an 0.8% advantage over high-volatility stocks and a shocking 2.8% difference on a dollar-weighted basis, suggesting volatility makes investors lose their nerve in addition to the innately inferior performance. Is it reasonable to give them a neutral weighting in a portfolio?

Not sure what you mean about funds of funds.

Vanguard sells several funds of its own funds and charges only the pro-rated expense ratio of the components (unlike most FoF managers who add a considerable amount to compensate themselves ... a favorite of the hedge fund world)

Posted by: G4 | Jan 23, 2007 6:24 PM

LIFE INSURANCE

I've not yet finished the tax and insurance courses but here's what I've learned about life insurance.

1. There are three parties to a life insurance contract: the insured, the owner (the person paying the premiums) and the beneficiary.

These can be three people (or trusts) or two or one.

The contract escapes income taxes in any event but it escapes estate taxes only if the insured is not the owner and/or beneficiary (in which case it becomes part of his estate).

Thus the popularity of having trusts be the owner of life insurance policies.

2. The "investment" gimmicks built into a lot of life insurance policies ("cash value", variable annuities, and such) are truly terrible investments with fees that would make you reach for your shotgun.

I'm not sure how much you want to automate the process. Although it won't be a full-time job, managing your portfolio will be something you will be taking an active role in.

When major asset classes are diverging significantly, I suspect you'll know just from reading the papers.

I've added two features:

1. New money market choices just to illustrate how bad the Financial Services industry really is.

2. A new spreadsheet to allow you to calculate after-tax yields; on the Utilities page labeled AFTER-TAX YIELDS

Posted by: G4 | Oct 23, 2006 2:22 PM

Pretty neat. I'm not clear how much flexibility could be built in. For example, the range above and below target before you would want to rebalance. The range would be smaller for commodities than equities.

And the trend of the target, in the past month, two months, three months. Possibly the trend of the actual in that time, too. Or some measurement of volatility of each component, since some are likely to be more volatile lately than others. Since this gets to be extensive, perhaps pop-ups are necessary. Maybe graphs would be more useful. Perhaps red colors would be useful to indicate an element needs rebalancing, or special email notifications.

For years, all I looked at was new highs and new lows. If one of my holdings wasn't on either list, it was fluctuating within the range of uneventfulness. The same thing might apply here, too. Perhaps all you want to display are things that have gone on the warning list.

If everything adds up to 100% at all times, it makes a difference which one moved actively, and which ones moved in the other direction passively. At least theoretically, you have a choice of rebalancing with fresh money, or rebalancing by selling something. If stocks go up and bonds go down, you have a harder decision than if stocks alone go up and bonds remain stable.

And if you have established a neutral range, you might rebalance down to the lower bound if stocks are going up dramatically; conversely, if stocks are just creeping up slowly, you might be inclined to rebalance down to the upper bound.